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Discussion Paper
DEVELOPMENT POLICY ISSUES SERIES

4
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\ Report No.

PFER52

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The Costs and Benejfits of Being a Small, Remote, Island, Landlocked or Mini-State Economy
T.N. Srinivasan March 1985

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Office of the Vice President

Economics and Research

The views presented here are those of the author, and they should not be interpreted as reflecting those of the World Bank,
K

THE COSTS AND BENEFITS OF BEING A SMALL, REMOTE, ISLAND, LANDLOCKED OR MINI-STATE ECONOMY

by

T.N. Srinivasan

March 1985

The author is Professor of Economics, Yale University and Consultant, World Bank. The author thanks Bela Balassa, John Duloy, Gregory Ingram, Deepak Lal and Sarath Rajapatirana for their valuable comments.

The World Bank does not accept responsibility for the views expressed herein which are those of the author(s) and should not be attributed to the World Bank or to its affiliated organizations. The findings, interpretations, and conclusions are the results of research supported by the Bank; they do not necessarily represent official policy of the Bank. The designations employed and the presentation of material used in this document are solely for the convenience of the reader and do not imply the expression of any opinion whatsoever on the part of the World Bank or its affiliates concerning the legal status of any country, territory, city, area, or of its authorities, or concerning the delimitations of its boundaries, or national affiliation.

Abstract Any index of smallness is somewhat arbitrary, but common practice has been to use population and income criteria. Experience suggests that smallness is neither a necessary nor sufficient condition for poor development performance. Various fora have raised two important issues: 1) Do small economies face special problems that call for special attention? and 2) If so, are these problems already being addressed? This paper analyzes these broad issues by considering the problems that small economies are most often alleged to face, including: absence of economies of scale; vulnerability; remoteness and other factors that raise transport costs; reduced access to capital markets; problems of macro-economic policy dependence; and overstatement of real income. After addressing these issues, the author concludes by asserting: "It would appear that many (though not all) of the alleged problems of small economies are either not peculiar to small economies or can be addressed through suitable policy measures."

Table of Contents

Page No.

I.

What Are Small Economies?..

..................................

II.

Problems of Small Economies A. C. D. E. F.

...............................

8 10 13 18 19 25 27

B. Vulnerability

Economies of Scale ................................. .......................... Remoteness and Other Factors Affecting Transport Costs ....................... Access to Capital Markets ......................... Macro-economic Policy Independence ................ Real Income Comparisons ...........................

III. Conclusions

............................................. e f 30

Tables Number and Distribution of Countries Classified by Population Size (mid-1983) ............................ Distribution of Countries by Population Size and Per Capita Income, 1982...... e................................. Growth of Real GNP Per Capita, 1970-1980 .. Per Capita Net Resource Flows in 1982 (US$) ..................

6
21

e.. ...........

Per Capita Grpss Domestic Product in IJS Dollars at Official Exchange Rates, and in International Dollars, 1975.. ................................................

29

The Costs and Benefits of Being A Small, Remote, Island, Landlocked or Mini-State Economy

T.N. Srinivasan

I. What Are Small Economies? In order to classify an economy into two citegories -"not small" -one obviously needs two things:

"small" and

an index or measure of the

size of an economy according to some concept of size, and a cut-off point with respect to this index so that all economies with an index value at or below this cut-off value are classified as small. In the theory of international

trade the concept of size is market power, i.e. the ability of an economy to affect its own terms of trade by changing its volume of trade, and the cut-off point is zero. As an operational concept, this is not very useful --apart

from the problems in empirically determining whether a country has market power, the fact that such power may be commodity-specific (that is, a country may have positive market power in some commodity markets but none in others) makes it difficult to generalize it into an economy-wide concept. Another index of size that has been proposed is the size of a country's potential market for commodities and services measured in terms of the country's real gross national product (GNP) or better still, gross domestic expenditure (GDE).
tountry --

Of course, it is recognized that a poor

may still be

in the sense of having a low per capita income --

large in terms of its GNP because of its large population but small as a potential market. For example, if the income distribution is not unduly

concentrated, the bulk of the large population in such a low per capita income economy will be too poor to be potential demanders of anything but basic

commodities.

This has been taken to imply that an index of market size for

manufactured goods has to be related to the total consumption of such goods which in turn has to be based on population, per capita income and some measure of the concentration of the distribution of income. If one goes

beyond the market for manufactured goods to basic services covering transportation, health and sanitation, edu2ation, etc., then the geographical area of a country, the average density of its population settlements, a measure of distribution of the density across settlements, and even the agesex distribution of population become relevant as possible determinants of the size of the market for such services. In an ever-changing world the definition of smallness may also have to change, particularly in response to technological change. For instance,

the "optimum" size of a plant for producing ammonia (an input in the manufacture of nitrogenous fertilizers) increased with the development of high pressure compressors. Given the vagueness of the concept and the arbitrariness inevitably involved in choosing an index of size and a cut-off point with respect to this index, the literature on "small" economies appears to have settled on a country's population as the primary measure of size, with total GNP as a secondary measure, rather than attempting to develop anything more sophisticated. The population cut-off point in defining smallness has been Ir cross-country regression

set anywhere between 1.5 million to 5 million.

analysis of development processes Chenery and Syrquin 1/ use population as a measure of size or scale of an economy, and countries with less than 5 million population are classified by them as small.

1/

Chenery and Syrquin (1975).

-3Denoting a country with a population of less than 1.5 million persons as very small and that with a population between 1.5 million and 5 million persons as small, the data from the 1983 and 1985 World Bank Atlas for 189 countries and their dependent territories indicate (see Tables 1 - 3 for details) that:
--

42 independent countries and 25 dependent territories are very small and 33 independent countries are small. 42 very small countries as mini-states. One could characterize the

--

38 countries and 24 dependent territories are islands, of which 24 countries and 22 dependent territories are very small and 4 countries and 2 dependent territories are small.

--

26 countries are landlocked, of which 5 are very small and 6 are small. The remaining 15 landlocked countries have populations

greater than 5 million. Available GNP figures show that:

--

Of the 67 very small economies 4 can be classified as low-income with per capita income below $410 but 21 can be classified as uppermiddle-income with per capita GNP exceeding $1,670.

--

For the 33 small economies 6 are considered low-income while 7 are upper-middle-income.

--

For those 46 economies which are both very small and islands, 3 are low-income, 18 are upper-middle-income.

--

Of the 6 small island economies none are classified as low-income and 2 are upper-middle-income.

Table 1:

Number and Distribution of Countries a/ Classified by Population Size (mid-1983)

Population Size (millions)

Africa

Asia

Europe

Oceania and Indonesia

North and Central America b/

South America

Independent Countries

All Regions Dependent Territories

Total

A. Less than 1.5 1.5 - 5.0 More than 5.0 Total 15 (2) 11 27 53 8 (1) 9 (5) 8 4 22 (1) 22 38 35

ALL ECONOMIES 16 (9) 6 8 30 3 (1) 2 8 13 42 33 88 163 25 1 26 67 33 89 189

16 (7) 2 2 20

B. Less than 1.5 1.5 - 5,0 More than 5 Total 6 (1)

-

ISLAND ECONOMIES 15 (8) 2 (1) 20 -

1 7

2 1 4 7

7 (4) 1
-

16 (9) 2 (1) 2 20

24 4 10 38

22 2 24

46

6
10 62

C. Less-than 1.5 195 - 5.0 More than 5 Total 3 3 8 14 1 2 2 5 1 4 5

LANDLOCKED ECONOMIES
-

1 1 2

5 6 15 26

5 6
15 26

a/ Figures in parentheses indicate number of dependent territories. b/ Includes Caribbean nations. World Bank Atlas, 1985, World Bank, Washington, D.C.

Source:

-5-

Table 2:

Distribution of Countries by Population Si-e and Per Capita Income, 1982 a! A. Very Small and Small Economies OCEANIA & INDONESIA S VS 4 5
-

Country Grouping b/ Low-income Lower-middle-income Upper-middle-income High-income Oil exporters Industrial Data not available TOTAL

AFRICA, S VS 4 6 4 3 3 4 15 1 11

ASIA S VS
-

EUROPE S VS 2 7 9 B. 3 1 4

NORTH AND CENTRAL AMERICA S VS 7 8

-

SOUTH AMERICA S VS 1 2
-

1 5 2 8

4 1 3 8

1 -

4 2
-

1 1
-

ALL REGIONS S VS 6 4 9 16 7 21 5 8 13 67 2 4 5 33

TOTAL 10 25 28 7 12 18 100

7 16

1
2

1
16

Country Grouping b/ Low-income Lower-middle-income Upper-middle-income High-income Oil exporters Industrial Data not available TOTAL

AFRICA VS S O 3 -1

ASIA VSS O

--

1
- 1 1 1

1
2 -

Island Economies OCEANIA & INDONESIA EUROPE VS S O VS S O - -9 1 1 5 - 2 - -

NORTH AND CENTRAL AMERICA S 0 VS I 1 1 5 1 9

SOUTH AMERICA VSS O - - = - - - - -1 - -

ALL REGIONS VSS O - 3 15 2 3 18 2 1 6 2 3 46 2 1

TOTAL 6 20 21

1
10 4 62

1
-

1
2

5 7 C.

1 -

2 16

1 1 - 2 2

1 15

1
3

6 -

1 4

1 -

6 10

Country Grouping b/ Low-income Lower-middle-income Upper-middle-income High-income oil exporters industrial Data not available TOTAL
-

AFRICA VS S O - 3 6 3 - 2 - - -

ASIA VS S O - - 1 - - - - - - 1 2
-

Landlocked Economies OCEANIA & INDONESIA EUROPE VS S O VSSO

-

NORTH AND CENTRAL AMERICA S 0 VS

-

SOUTH AMERICA VS S O
-

ALL REGIONS VSS O 3 7 3 1 3

TOTAL 10 7

1
-

1
-

1
-

2
1 -

---

2
-

1
1 2

2 2

3 5 26

3 3 8

1 2 2

1-4

-1

5 6 15

a/

I.ncluding dependent territories, Countries are divided by size according to population: vs - very small: population less than 1.5 million s - small: population between 1.5 and 5 million o - other: population greater than 5 million income categories are compatible with 1984 WOR per capita classifications: b/ Low-inccme: S0 - $410 Lower-middle-income: $410 - $1670 Upper-middle-income: 31670 - 56900 High-income oil exporters: $6240 - $21,340 Industrial countries: $4810 - $16,390 Source: World Bank Atlas, 1983, 1985, World Bank, Washington, D.C.

-6-

Table 3:

Growth of Real GNP Per Capita, 1970-1910 a!

Africa

Asia

Europe

Oceania and Indonesia

North & Central America

South America

Total All Regions

ALL ECONOMIES Negative growth rate Zero to +2% growth rate Greater than +2% growth rate Data not available TOTAL 17 14 17 5 53 2 6 20 10 38 1 5 22 7 35 4 5 4 7 20 8 7 13 2 30 2 4 7 13 34 41 83 31 189

VERY SMALL ECONOMIES Negative growth rate Zero to +2% growth rate Greater than +2% growth rate Data not available TOTAL 3 1 8 3 15 1 2 4 1 8 1 7 1 9 4 2 3 7 16 SMALL ECONOMIES Negative growth rate Zero i'o +2% growth rate Greater than +2% growth rate Data not available TOTAL 6 5 11 1 4 3 8 3 1 4 2 2 OTHER ECONOMIES Negative growth rate Zero to +2% growth rate Greater than +2% growth rate Data not available TOTAL 8 8 9 2 27 1 3 12 6 22 5 12 5 22
-

6 2 7 1 16

1 1 1 3

16 8 30 13 67

2 3 1 6

2 2

8 11 10 4 33

1
3 4 8

1 1 2

1 5 1 7

10 21 43 14 88

a!

Including dependent territories. World Bank Atlas, 1983, World Bank, Washington, D.C.

Source:

-7-

--

Of the 6 small landlocked economies only 3 are low-income, none of the 5 very small landlocked economies fall into this category; there are no very small or small landlocked economies which are uppermiddle-income. The data on the average rate of growth of real GNP per capita during

1970-80 (available for 158 economies) shows that: The economies of 34 countries had negative growth rates. Of these

34, 16 (of which 14 are islands) were very small and 8 (1 island, 2 landlocked) were small. Among the remaining 10 countries, 6 were

landlocked and 1 was an island. On the other hand, 83 economies had growth rates of real GNP per capita of greater than +2 per cent. Of these, 30 (of which 19 are

islands and 4 are landlocked) are very small and 10 (of which 2 are islands) are small. The United Nations characterizes 36 countries as least developed, of which 12 are very small, and 9 are small and the remaining 15 have population greater than 5 million. A total of 15 least developed countries (3 very

small, 4 small and 8 others) are landlocked, and 5 are very small islands. The rest, 16, are neither landlocked nor islands. Thus, it would appear that

if low population size is a criterion of smallness, a significant number of least developed countries are very small or small economies, and/or islands or landlocked countries. And in 8 least developed countries per capita real GNP

had declined in the decade 1970-1980. Presumably, the expected interrelationship between smallness, lowincome, poor growth performance and geographical isolation reinforced by specific country cases is what prompted international agencies to focus

-8-

attention on the least developed, island and landlocked countries.

On the

other hand, the fact that many small economies (a third of them including islands like Singapore and Trinidad and Tobago) are neither poor nor even in some respects less developed, and many have experienced significant positive growth in per capita income and several have grown very rapidly, cannot be altogether ignored, particularly from the point of view of analyzing policies that may retard or promote the growth of a small economy. Smallness obviously

is not a necessary nor sufficient condition for poor development performance.

II. Problems of Small Economies

Among the international organizations, UNCTAD has probably devoted the most time and effort to the special problems believed to be characteristic of small island and landlocked economies. The Development Committee in

1982 1/ "noted the problems of small island and landlocked states, and recognized the urgent need to review mechanisms and adjustment prescriptions appropriate to the particular circumstances of such states." At the same

time, the Ministers of the Group of 24 2/ also "urged that the international community pay particular attention to small island and landlocked developing states, having regard to their limited size, their openness, their vulnerability to the vagaries of the international economic environment." They agreed with the Development Committee to an urgent need for "immediate action to review the mechanism and format of conditionality and the nature and

1/ Press Communique of the World Bank Development Committee, September 5,

1982.
2/ Communique of the Group of 24, September 3, 1982.

-9content of adjustment prescriptions requested by multilateral financing institutions in small island and landlocked economies." 1/ In the context of

graduation criteria (as contrasted with adjustment processes), the perceived problems of small economies have been raised in recent discussions at the World Bank. 2/ There are two related questions that need to be answered in addressing the concerns expressed above. The first is, of course, the

question of whether such economies do face special problems not faced by large or non-island or non-landlocked developing economies, and thus call for special attention. If there are indeed a number of such problems, a further

question arises as to whether they are already being addressed to a considerable extent in the operational policies of multilateral financing institutions and international agencies, and through bilateral aid programs. Besides these two broad questions, there is also the issue of whether the criteria actually used in implementing policies that are in principle fair to all, nevertheless are biased against small island economies. For instance, it

has been said that the use of real per capita national income in constant US dollars as a trigger in initiating a graduation exercise is subject to such a bias because it is suggested that converting conventionally measured real national income in domestic currency into US dollars through official exchange

1/ Communique of the Group of 24, September 3, 1982. 2/ See World Bank document EDS84-4, "Executive Directors' seminar February 21, 1984, Special Problems of Very Small Economies" . In addition, the economic difficulties faced by small island economies were the subject of a paper prepared for members of the Executive Board of the IMF entitled: "Small Tropical Island Countries - an Overview", Dec. 19, 1983, EBD/83/325.

10

rates will overstate the "true" income of small economies relative to large economies. The special problems most often said to be faced by such economies can be grouped into the following categories: (A) Problems related to economies of scale and of agglomeration. (B) Problems of vulnerability, including susceptibility of these economies to external economic shocks because of their degree of openness and dependence on a few commodities or services for foreign exchange earnings, and to non-economic shocks such as natural disasters (cyclones, hurricanes, earthquakes, volcanic eruptions) and man-made shocks (epidemics, ecological degradation, denmographic
changes, etc.).

(C)

Problems, of landlocked countries and islands remote from the nearest natural market of any reasonable size, that arise from scale economies and technological changes in transportation.

(D) Problems of access to markets for exports and in particular to external capital markets. It can be argued, however, that these

problems are in fact a reflection of the above points (1) and (3). (E) Problems of limited policy independence, particularly in respect of macro-economic policies relating to exchange rates, monetary policy, etc. (F) Problems of real income comparisons.

A.

Economies of Scale

The exploitation of economies of scale in the manufacture of goods traded in international markets need not, of course, be constrained by the

limitations imposed by the small size of the domestic market.

However, to the

extent remoteness i.tcreases the cost of transportation to the world markets, the returns from manufacture for exports are reduced relative to more favorably located competitors. On the other hand, the same factor provides Be that as it

greater natural protection for import-substituting manufacture.

may, even if there are no constraints on size of the market for a product because of possibilities for export, to the extent the penetration into foreign markets depends on the experience gained in producing and selling in the domestic market, smallness of the latter may preclude export development. Since market size for this purpose is not measured just by the

size of a country's population, and is not directly related to its status as an island or its being landlocked, a similar problem arises in any country (small or large) with a limited domestic market. The significance of this The analysis of

problem is, in the final analysis, an empirical matter.

Chenery and Syrquin (1975) suggests that there are substantial differences even among small countries in their sources and patterns of industrializations, with some successfully industrialized small countries having a composition of exports similar to that of large countries even though they depend on trade to a greater extent. In primary-product-oriented small

countries, on the other hand, they found that industrialization takes place later and is due to import-substitution and perhaps to inapprop7iate policies as well. l/

1/ In the study of the "Growth Experience of Small Economies", Metzler and Hughes found that there was no "significant correlation (positive or negative) of scale with growth for small and large countries", see Jalan (ed.) (1982), p,91 .

12

It has been suggested that indivisibilities and consequent economies of scale in the production of internationally non-traded goods and services (particularly those relating to infrastructure) have the effect of raising unit cost, both of capacity creation and of production in small economies. For instance, it has been estimated that small countries experience an average of 65 percent cost disadvantage in creating additional thermal capacity for power generation. However, for small countries with high population density

(such as Barbados) this disadvantage is only 20 percent. 1/ To the extent many of the non-traded goods or services are intermediate inputs in other activities (including, in particular, foreign exchange earning activities) international competitiveness of small economies may be affected. The

significance of this factor depends, in part, on the share of capital costs (which are affected by economies of scale) in the unit cost of production of infrastructure, and on the share of infrastructural costs in the cost of production of other goods and services. Obviously, the smaller are these

shares, the more limited is the disadvantage of small economies on this count. Besides, some of the infrastructural activities such as electric power

generation, education, communications and health facilities can be shared by neighboring countries if they are not separated by cost-raising natural or man-made barriers -- in other words, even some infrastructural services could be internationally traded. Of course, island economies that are remote from

the nearest continental landmass do not have this option.

1/ Legarda (1983).

13 -

It is also suggested that indivisibilities in political and administrative structures raise costs for small economies (e.g., a very small and a very large country will each have one President or Prime Minister, the number of ministers and government departments needed to take care of economic development is not proportional to a country's size). On the other hand, it

has been argued that there are social and political advantages associated with smallness, e.g., social and political cohesion, and fewer vested interests. 1/ In the extreme, one could envision a very small economy facing a choice between the cost of running their own government infrastructure or becoming part of a larger community. However, as F. Doumenge points out,

small islands may deliberately choose to retain their separate status rather than form a larger political unit by joining with other islands for the reason that "islanders are never happier with insularity than when asserting that they are completely different from their neighbors, particularly in regard to language, customs and laws, legal and administrative regulations, currency, system of government and all other symbols which demonstrate the small selfcontained universe. Consequently, small islands tend to band together only

under the influence of external forces...." 2/

B.

Vulnerability

Since many of the small island countries are located in the so-called loring of fire", they are susceptible to volcanic eruptions and earthquakes. Some of them are also in the tropical latitudes in which cyclonic storms and

1/ 2/

Metzler and Hughes in Jalan (ed.) (1982), pp. 85-86. Doumenge (1983).

14 -

hurricanes develop.

Since any country (large or small) located in these areas

is subject to such natural disasters, the particular vulnerability of small (island) economies is attributed to the disproportionate effect which natural disasters could have on them. For instance, a strong earthquake could destroy

a large proportion of the housing stock and public buildings on a small island. Similarly, an epidemic could affect a large proportion of its

population, although their possible remoteness from the nearest continental population centers provide significant protection from the occurrence of such an epidemic. Some islands representing the tip of volcanoes may not be

suitable for agriculture but the sea itself is a resource for them, though its exploitation may require resources that a small economy may be unable to provide itself. The presumption that such vulnerability imposes relatively higher costs on small economies also arises from the fact that the "self-insurance" available to large economies is not feasible for them. That is to say, a

large economy can absorb a local disaster by spreading its cost over the rest of the economy unaffected by the disaster, while in a small economy there is likely to be no sector unaffected by the disaster. On the other hand, even a

small economy may have opportunities for some self-insurance which can help spread the effects of a disaster over other periods. For example, a buffer

stock of food built during good crop years can help cushion the impact of a severe drought which reduces crop yields drastically. More generally, in an

open economy buffer stocks of generalized purchasing power in terms of foreign exchange reserves accumulated over normal years can help augment, more economically, domestic production shortfalls due to a natural disaster through

15 -

imports.

In the absence of o:her cheaper ways of insurance, the return to Of course, disruptions in the provision
electric power) goods due to a disaster

such stocking activity can be high.

of non-traded and non-storable (e.g.,

cannot be made good by imports and stock depletion. are likely to be of relatively short duration.

However, such disruptions

At the same time, the

international community has repeatedly demonstrated its willingness to provide disaster assistance. While the potential exists for a small country to insure itself against major losses, and in fact all countries need to undertake some level of insurance against unforeseen negative events, it is also argued that a small and poor economy cannot afford to tie up a volume of resources in buffer stocks of commodities and foreign exchange or purchase insurance sufficient to adequately cover these risks. the economy. These forms of insurance do represent a cost to

If the probability of a disaster occurring is high, the The net result is that these

corresponding insurance costs will also be high.

countries, if they are in fact more vulnerable, are more likely to have to devote more of their available resources to insurance than other countries. Small economies allegedly suffer increased economic vulnerability because, being necessarily more open than large economies, they are more affected by shocks originating elsewhere in the world. Further, being small

and hence specialized in a few exports while widely dispersed in the composition of imports, any external shock that affects the market only for their exports has a disproportionate effect on their economies. Also, a small

economy in the sense of not having or not perceiving to have any influence on its own terms of trade does not have the option of adjusting to external demand shocks by varying its optimal export tax. It is of course, true that

16 -

external shocks are transmitted to the domestic economy to a greater extent, the more open an economy happens to be. Also, small economies with relatively

few and less serious distortions in their foreign trade can and do exploit their comparative advantage to a much greater extent than large economies. In

any case, if one takes into account gains from trade and the relative severity of shocks originating at home compared to those originating abroad, it is by no means always the case that, on balance, small economies have been pushed (because of their smallness) to a degree of openness that is not optimal compared to their larger cousins. Further, not all small countries are

affected to the same extent by external shocks, partly because of the variations in the composition and size of their export basket. Sonme had more

stable export earnings in the period 1967-81 than other not so small but comparable countries. It is but natural that given a narrow resource base, an economy may specialize in the production of a few commodities and services, although some otherwise small economies (Singapore or Hong Kong, for example) apparently have resources, mainly entrepreneurship and skilled labor, that appear to have enabled them to have a diversified production structure. There are some

otherwise large economies which have at least as high a commodity concentration, in their exports if not in their total production. small and having a high commodity concentration are not synonymous. Thus, being In any

case, the really important point is that a high commodity concentration, either in export earnings or in domestic production (and in domestic value added), need not imply that the changing fortunes of exports or of domestic production are mirrored in foreign exchange expenditure on imports or in aggregate domestic expenditure. To the extent that an economy invests in an

17

appropriately diversified portfolic of domestic assets (inclusive of inventories) and foreign assets (particularly reserves) expenditures can be more stable than earnings and incomes. Again the issue is whether the probability of major fluctuations constitute a substantial cost for many of the small and low-income countries which exceeds that imposed on other countries. Furthermore, portfolio choice

and management are generally not inexpensive in terms of skills, information needs, access to swift communication channels, etc. And fixed costs involved

in setting up the needed institutions may make it prohibitively expensive for "small" economies. One could envision that several "small" countries could However,

share in the costs of setting up and operating such an institution,

there are numerous political and operational problems to such arrangement which make this an unlikely and unrealistic option for most countries. Apart from diversification of its financial asset portfolio, an economy may have the option of diversifying its portfolio of human capi:al, i.e., have some of its workers emigrate and remit part of their earnings abroad to their families at home. A number of island economies appear to have

a significant proportion of their labor force working abroad. Appropriate choice and management of the asset portfolio, coupled with the use of international facilities (e.g., the IMF compensatory financing, food facility, STABEX) available to finance temporary (and reversible) shocks and to ease the cost of adjustment to permanent shifts, can reduce the unfavorable effects of external shocks. Given these facilities and

small countries' access to them, it is unclear as to ;hether any additional facilities aimed specifically at helping these countries are needed.

18 -

C.

Remoteness and Other Factors Affecting Transport Costs It has been argued that the location of many island countries far

away from the nearest major port places them at a considerable disadvantage in spite of the relative cost advantage of sea transport over land transport. It

is also claimed that technological change in air and sea transportation in the form of the long-haul wide-bodied passenger jets and containerized cargo traffic has resulted in economies of cargo size and, as such, some island ports handling limited amounts of cargo are left out of trunk routes altogether or have become less frequent scheduled ports of call. And

alternative arrangements for connecting these islands to the nearest major port on a trunk route could increase transportation costs. In the case of

landlocked economies, besides their having to bear relatively higher costs of land transportation, dependence on their neighbors' transportation network for their access to the sea places them in a disadvantageous position because: the design of the network and its operation need not necessarily be based on their requirements; and it has been argued, the transit countries have at times utilized their monopolistic control over land transportation to charge additional "rents" on transshipments. The small size in combination with remoteness is also likely to lead to stronger tendencies for market imperfections and monopolistic situations in the country itself. This results from the fact that, ceteris paribus, the

smaller the market and the higher the transportation costs, the greater the danger that competition will not be effectively felt by individual producers (domestic and foreign) in the small country, thus permitting the producer to capture and exploit a monopolistic position in specific markets. Given this

19 -

danger, small and remote economies need to be vigilant of this potential and take steps to reduce or prevent its occurrence. It is undoubtedly true that the high costs of transport can reduce their foreicga trade just as tariff barriers can. One can even show how, in a

simple Ricardian model, the introduction of sufficiently high transport costs will eliminate trade altogether. As a consequence, compared to an otherwise

identical economy, an unfavorably located island economy will have lower real income. Of course, the cost of its remoteness can be taken into account by

appropriately computing real income comparisons (section 6 below discusses these comparisons in some detail) when per capita incomes are being used as a decision criteria, e.g., aid allocation, graduation. Focussing on high

transport costs per se, however, ignores the extent to which economies have adapted to these costs by the choice of its export products; a classic example is Switzerland, which produced and exported high value but low weight per unit value products such as watches and instruments. There is yet another sense in which remoteness is sometimes used. It

is argued that many small economies (in particular, dependent territories) are at the remote periphery of the centers of power at which decisions affecting them are made. To the extent such remoteness means less interference from the In any case, remoteness in this sense areas within a large economy

center, it could have positive effects.

is not unique to small island territories --

could be remote from the center of decision-making.

D.

Access to Capital Markets One of the disadvantages from which small economies are said to

suffer is their alleged limited access to private external capital.

The

20 -

limited evidence sometimes offered on the basis of observed flows of private capital is hard to interpret. Such flows are influenced by the general

policies towards external capital, and a country's policies perceived to be unfavorable by the market can result in limiting capital flows to that country regardless of its size. And the policy stance of a country may affect the

perception of foreigners of the political risk associated with lending or investing in that country. It would appear that some small economies have

succeeded not only in borrowing abroad in private capital markets but also in attracting private foreign investment, particularly by multinationals. island countries have attracted off-shore banking and tax sheltering investments. However, this is perhaps more a consequence of the banking A few

regulation and tax codes of rich and large countries than of comparative advantage of small islandsl In any case, whether or not small economies are

disadvantageously placed with respect to access to private capital markets, they seem to receive much higher levels of official development assistance on a per capita basis than do many large economies, as is evident from the data presented in Table 4. 1/ In almost every region, very small and small countries received much higher net official transfers per capita and a larger share in terms of IDA loans than large countries.

1/ An analysis of this small country bias 4n aid allocations is contained in Isenman (1976).

Table 4:

Per Capita Net Resource Flows in 1982 (US$) Official Total

'-;2/--

IDA

Total

Private Financial Markets

AFRICA, SOUTH OF THE SAHARA Very Small Countries Botswana Cape Verde Comoros Djibouti Gabon Gambia Guinea-Bissau Lesotho Mauritius Seychelles Swaziland Average: Very Small Countries Small Countries Benin Burundi Cent. Africa Rep. Chad Congo Liberia Mauritania Sierra Leone Somalia Togo Average: 22.7 80,0 39.4 59.1 0.3 36.5 26.9 31t4 28.8 89.0 48.5 -0.1 2.5 2.3

0ob
5,*,

0.0
1.6

0.0
1.6

0.0
0.0 6.2 3.4 5.9 .1 0.0 0.5

10.6
-146.0 0.4 .5 -1.1 20.4 0.0 -6.0

-1.5
-185.6 -2.2 .8 -1.1 21.6 0.0 6.0

42.1

1.9

-10.6

-14.4

12.6 11.1 7.8 0.0 54.5 22.8 113.9 4.5 17.7 14.9

2.9 4.2 0.8 0.0 4.8 3.7 3.3 1.8 3.7 3.9 2.9

7.2 0.2 0.1 0.0 145.2 -2.7 10.5 -6.8 7.6 -0.7 16.1

4.3 0.4 0.0 0.0 109.0 -2.0 7.1 -1.7 7.6 -0.7 12.4

Small Countries 26.0

Other Countries Burkina Faso Cameroon Ethiopia Ghana Guinea Ivory Coast Kenya Madagascar Malawi Mali Niger Nigeria Rwanda Senegal Sudan Tanzania Uganda Zaire Zambia Zimbabwe Average: Average:

8.0 9.6 2.4 4.9 3.7 31.2 15.1 17.4 8.8 17.4 6.9 2.0 4.5 27.7 20.0 9.8 5.0 4.0 25.6 16.7

1.6 3.4 0.8 1.2 2.0 0,0 4.7 3.6 4.0 2.0 2.1 0.0 2.0 3.4 4.2 3.9 2.8 1.2 1.2 0.0 2.2 2.3

2.0 -5.5 0.3 -.2 2,0 20.0 -6.6 5.2 -2.7 0.2 1.6 11.8 0.0 1.2 -2.6 0,0 -1,0 0.4 10.0 45.5 4.1 3.1

1.7 -5.3 -0.1 0.0 0.7 23,3 -4,0 4.0 -1.7 0.2 2.4 11.8 0.0 2.7 -2.6 -0.1 -0.3 0.0 6.3 42.0 4.1 -0.7

Other Countries 12.0 All Countries 23.5

22

Table 4:

Per Capita Net Resource Flows in 1982 (US$) (continued) Official Total IDA Private Financial Markets

Total

NORTH AFRICA AND THE MIDDLE EAST Ver ~Small1 Oman Small Countries Jordan Yemen, PDR Average: Small Countries Other Algeria Egypt Lebanon Morocco Syria Tunisia Yeman, AR Average: Average: 21.5 13.2 1.0 31.9 16.5 39.0 29.0 Other Countries 21.7 All Countries 30.9 0.0 0.0 0.0 0.0 0.2 0.0 2.3 0.4 -26.1 4.2 -12.3 37.1 -2.9 -16.3 0.1 -2.3 11.3 -16.8 -1.8 -12.3 34.5 -.9 -18.2 0.2 -2.2 12.0 86.6 67.4 77.0 1.2 9.0 5.1 -9.1 0.0 -4.6 -8.7 0.0 -4.4 2.7 0.0 138.7 143.8

le3

MORE DEVELOPED MEDITERRANEAN Very Small Cyprus Small Israel Other Greece Malta Portugal Turkey Yugoslavia Hungary Average: Average: 44.9 1.7 51.1 20.2 7.6 5.8 Other Countries 21.9 All Countries 53.2 0.0 0.0 0.0 -0.1 0.0 0.0 0.0 0.0 67.4 0.0 166.6 1.4 12.1 15.2 43.8 53.2 68.2 0.0 165.5 0.6 12.4 0.0 41.0 51.1 215.5 0.0 30.4 32.5 79.0 0.0 132.6 129.7

23

Table 4:

Per Capita Net Resource Flows in 1982 (US$) Official IDA Total Total SOUTH ASIA

(conL.nued) Private Financial Markets

Very Small Countries Maldives 57.7 0.6 -2.5

-1.2

Other Bangladesh Burma India Nepal Pakistan Sri Lanka Average: Average: 6.3 8.1 1.8 4.4 7.2 11.1 Other Countries 5.5 All Countries 13.8 2.0 1.4 1.5 2.2 1.6 3e5 2.0 1.8 0.1 1.4 0.7 0.0 -0.6 7.7 1.6 1.0 0.2 0.9 0.7 0.0 -0.5 6.0 1.3 0.9

EAST ASIA AND THE PACIFIC Very Small Countries Fiji Singapore Solomon Is. Vanuatu Western Samoa Average: Very Small Countries Small Countries Papua New Guinea Other Hong Kong Indonesia Korea Malaysia Philippines Thailand Average: Average: 1.1 8.8 27.0 13.6 0.9 14.7 0.0 0.5 0.0 0.0 0.2 0.4 0.2 1.3 -2.4 11.6 27.8 16.8 18.8 8.2 13.5 9.7 -2.2 9.0 37.2 165.1 18.1 6.3 38.9 17.4 11.2 2.8 33.4 33.6 71.7 -11.4 18.0 13.0 40.3 0.0 0.0 0.4 0.0 7.0 -1.8 70.4 0.0 0.0 -6.3 0.0 62.7 0.0 0.0 -6.3

26.3

1.5

12.5

11.3

Other Countries 11.0 All Countries 16.1

24

Table 4:

Per Capita Net Resource Flows in 1982 (US$) Official Total IDA Total

(continued) Private Financial Markets

LATIN AMERICA AND THE CARIBBEAN Very Small Countries Bahamas

Barbados ^

17.0
85.7

0.0
0.0

170.6
165.3

153.7
165.3

Belize Guyana Trinidad & Tobago Average: Very Small Countries Small Countries Costa Rica Honduras Jamaica Nicaragua Panama Paraguay Uruguay Average: Other Argentina Bolivia Brazil Chile Colombia Dominican Rep. Ecuador El Salvador Guatemala Haiti Mexico Peru Venezuela Average: Average: Sources:

14.0 68.5 -2.7 36.5

0.0 0.4
000

16.7 -8.5 4.0

22.7 2.4 4.0

0.1

70.0

69.6

53.2 35.2 81.2 52.4 55.6 32.0 17.3 Small Countries 46.7

0.0 0.7 0.0 0.7 0.0 0.0 0.0 0.2

2.5 3.0 -17.3 -6.0 178.1 44.1 153.4 51.1

0.9 5.1 -9.6 -6.1 178.1 47.4 152.7 52.6

4.4 13.7 5.0 -8.2 13.9 54.0 -16.3 25.3 34.7 9.3 24.4 19.4 3.3

0.0 1.9 0.0 -0.1 0.0 0.0 0.0 -0.1 0.0 2.7 0.0 0.0 0.0 0.3 0.2

43.1 -2.1 25.8 79.0 26.7 -9.8 -17.1 0.6 5.6 0.2 86.2 34.0 23.2 22.7 40.0

8.6 -2.5 26.7 83.8 23.5 -9.6 -16.4 0.6 5.6 -0X1 86.5 26.1 23.9 19.7 38.9 D.C.,

Other Countries 14.1 All Countries 27.7

World Debt Tables, 1983-84 Edition, World Bank, Washington, and World Tables, Third Edition, Volume 1: Economic Data, World Bank, Washington, D.C., 1983.

25 -

E.

Macro-economic Policy Independence It is argued that small economies have very little choice except to

be open; they have very little room for independent exchange rate and monetary policies; and the range of activities that can be taxed and on which public expenditures can be made are apt to be limited as well, thus restricting the scope of fiscal policies. It is clear that autarkic policies are likely to be

costlier for a small economy than for a large economy, and hence small economies are likely to be more open purely from self-interest. As a

consequence, such an economy has to retain its competitive edge in international markets, which in turn means that it cannot distort its foreign trade sector unduly nor for long through disequilibrium exchange rates, tariffs and/or quotas. Even though, in principle, it can operate a market for

foreign exchange and adopt a floating exchange rate regime, in practice it is more likely that a regime maintaining fixed parity with a single currency or a basket of currencies is likely to be adopted. Since the exchange rate of

currencies within the baskets are likely to fluctuate relative to each other and to others outside the basket, such fluctuations will be transmitted to the exchange rates of a currency that maintain a fixed par value to the basket. Ever since the early seventies' shift away from the Bretton Woods fixed parity system for the major international currencies and particularly since the progressive integration of international private capital markets, even large developed countries have found that the scope of independent (i.e., internationally uncoordinated) macroeconomic policies is limited. In any

case, the argument about lack of macro-economic policy independence boils dowm to the assertion that small open economies have greater difficulties in

26 -

successfully employing macro-economic policies to stabilize domestic incomes or prices in the face of external shocks. It is easy to see that if domestic

income generation is largely through a few export activities and the domestic consumption basket consists mostly of imported commodities and consumer prices influence wage rates, etc., external shocks in terms of changes in export and import prices affect domestic incomes and prices to a greater extent in a small open economy than in a more diversified and less open large economy. But the real issue is whether and to what extent a small country should seek to stabilize income generated and/or prices given the costs which the pursuit of such an objective could impose on a small economy and the practical limits the countries face in the development and maintenance of a diversified portfolio of domestic production and foreign exchange reserves. In chis context, it has been suggested that policy prescriptions relating to adjustment to external shocks have to be different in the case of small island developing economies. Often this suggestion is based on the

belief that in a large, mo-a diversified and less open economy, the effect of shocks will be relatively less severe and the cost of adjustment could be spread to a greater extent within the economy, yet little evidence that this is the case has been presented. Furthermore, the dictum to "finance shocks of

a temporary duration and reversible in direction" and "adjust to permanent shifts" applies equally to large and small economies. And the problem of

determining whether an observed shock falls into the 'temporary"f or "permanent" category is no easier in the case of large economies!

27

F.

Real Income Comparisons

It was argued in section 3 that the transport cost disadvantages of a remote' economy will be reflected in its real income, properly computed. Consider, for simplicity, two otherwise identical economies which face the same prices in world markets, one of which is located sufficiently close to these markets that the transport costs of taking its exports to and bringing its imports from these markets can be neglected, while the second is located so far that transport costs preclude its participation in world trade. further that there are no distortions in either economy. Assume

Clearly, if the

income (i.e., value added) in each of these economies is computed by valuing its net output at the common set of world prices, then the second, which is forced into autarky because of high transportation costs, will have a lower income than the first. The reason being that the first (the second) will have

an output composition that approximates the maximum income that can be achieved at world prices (domestic prices) and the two sets of prices differ because of transport costs. Even though in the above argument it is implicit

that both countries produce only internationally traded commodities, it can be shown to be valid even when non-traded goods are admitted into the analysis as long as they are valued at prices that equal the value of the inputs used in their production, the input prices being those prevailing in the first economy. In practice, real incomes in units of a common currency such as the US dollar are often computed by dividing the real income in national currency unit by the official exchange rate (the national currency price) of the US dollar. A number of arguments have been made suggesting that such a procedure

28 -

may be biased in some sense or the other against small economies, apart from the general (i.e., not specific to small economies) problem that per capita real national income is not necessarily a good index of the welfare of a country's population or that of its level of economic, social and institutional development. Since this problem is well understood and other

indices of social and institutional developments are often-used in conjunction with per capita real income, no further discussion of it is offered here. It is argued that in many small and poor countries there is a rich expatriate community which may be sufficiently large to pull the per capita income of the residents much above that of resident citizens. valid, this is easily addressed: However, if

given an adequate data base, per capita

incomes of resident citizens, or for that matter the per capita income of any other sub-group of residents, can be computed. An apparently more serious argument is that conversion at the official exchange rate understates the transport or other cost disadvantages of small island economies. One could interpret this as asserting that an

exchange rate that better reflects these costs will be higher than the official one. The results from the International Comparisons Project funded

in part by the World Bank seem to contradict this assertion (see Table 5): the exchange rate derivation index, i.e. the ratio of official exchange rate to the purchasing-power corrected exchange rate is greater than one for all the developing countries included in the project. In other words, allowing

for the differing relative purchasing power of currencies, applying a common set of prices representative of the world price structure to the quantities of the commodities and services entering into each country's final expenditure or GDP raises the per capita income of each developing country above the level

29

Table 5:

Per Capita Gross Domestic Product in US Dollars at Official Exchange Rates, and in International Dollars, 1975

Country Africa Kenya (shillings) Malawi (kwacha) Zambia (kwacha) Asia India c/ (rupees) Iran d/ (rials) Japan (yen) Korea (won) Malaysia (ringgit) Pakistan (rupees) Philippines (pesos) Sri Lanka (rupees) Syria (pounds) Thailand (baht) Europe Austria (schillings) Belgium (francs) Denmark (kroner) France (francs) Germany (DM) Hungary (forint) Ireland (pounds) Italy (lire) Luxembourg (francs) Netherlands (guilders) Poland (zlote) Romania (lei) Spain (pesetas) U.K. (pounds) Yugoslavia (dinars) Latin America and Caribbean Brazil (cruzeiros) Colombia (pesos) Jamaica (dollars) Mexico (pesos) Uruguay (N. pesos) North America US (dollars)

In US dollars a/ (1) 241 138 495

Per Capita GDP In international dollars (2) 470 352 738

Exchange-rate deviation index (2)/(1) 1.95 2.55 1.49

146 1,587 4,474 583 780 189 376 183 718 359 5,010 6,298 7,498 6,428 6,797 2,125 2,673 3,440 6,472 6,061 2,586 1,742 2,946 4,134 1,664

470 2,705 4,907 1,484 1,541 590 946 668 1,794 936 4,995 5,574 5,911 5,877 5,953 3,559 3,049 3,861 5,883 5,397 3,598 2,387 4,010 4,588 2,591

3.23 1.70 1.10 2.54 1.98 3.12 2.51 3.65 2.50 2,61

1.00 0.88 0.79 0.91 0.88 1.68 1.14 1.12 0.91 0.89 1.39 1.37 1.36 1.11 1.56

1,149 568 1,406 1,465 1,308

1,811 1,609 1,723 2,487 2,844

1.58 2.83 1.23 1.70 2.17

7,176

7,176

1.00

Converted at the official exchange rate. b/ The 1975 international dollar has the same purchasing power as a 1975 US dollar. cJ Reference year beginning April 1. d/ Reference year beginning March 21. International Comparisons of Source: Kravis, l.B., A. Heston and R. Summers, World Product and Income: Real Gross Product, The Johns Hopkins University Press, Baltimore, 1982, Table 1.2.

30 -

obtained by using official exchange rates.

On the other hand, an alternative

interpretation could be that even though the use of official exchange rates instead of the purchasing-power corrected one for conversion understates the "true" income of all developing countries, it understates it less in the case of small island economies so that they appear richer relative to other developing countries than they truly are. If this is valid, the use of

purchasing-power corrected exchange rates may make more small economies eligible for various concessions than the use of official exchange rates would suggest. However, there is no evidence that this argument is indeed valid.

In any case, even if data were available (which they are not) for the computation of purchasing-power corrected exchange rates for small island economies, a selective use of such rates for small island economies is obviously out of the question before making that move more locally. III. Conclusions

It would appear that many (though not all) of the alleged problems of small economies are either not peculiar to small economies or can be addressed through suitable policy measures. It is also the case that the transport cost

disadvantage that a small economy suffers because of its location will already be reflected in its real income. As long as operational decisions about a

country such as its graduation and its eligibility for various forms of concessions, etc., continue to be-based on flexible applications of a number of indices and criteria and not rigidly on a single index such as that country's per capita real income in US dollars at that official exchange rate, there is little danger that small island or landlocked economies would be unfairly treated. However, this is not to suggest that all is well with small

31 -

island or landlocked economies (which clearly they are not, as evidenced by the decline in per capita real GNP in several of them during the 1970s), nor to argue that the external environment for developing countries is currently buoyant. What is being suggested is that causes of economic and social

stagnation in some of these economies cannot be attributed to their smallness or similar exogenous characteristics nor to the failure or non-existence of international institutional mechanisms to address their development problems.

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7) Kuzne,ts, S., "Population Change and Aggregate Output", National Bureau of Economic Research, Demographic and Economic Change in Developed Countries, Princeton University Press, Princeton, 1960. 8) Legarda, Benito, "Small Tropical Island Countries: Washington, D.C., mimeo, December 6, 1983. An Overview", IMF,

9) OECD, Development Cooperation, Paris, 1983. 10) Phelps, E., "Models of Technical Progress and the Golden Rule of Research", Review of Economic Studies, 1966. Simon, J. and R. Gobin, "The Relationship Between Population and Economic Growth in LDCs", Research in Population Economics, 1980.
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12)

Progress Model: Interpretation and Generalization", Research in Population Economics, 1981. 13) UNCTAD, "The Incidence of Natural Disasters in Island Developing Countries", UNCTAD, TD/B/961, 1983.
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14)

Island Developing Countries: Issues for Consideration", UNCTAD VI, Item 13C - Policy Paper, June 1983.
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"Islands in the Sun --

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16)
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International Community", A/CONF104/2/Revised, 1983.